Saturday, February 09, 2008
1:42 AM

....What's caused the hullabaloo recently is the dive in non-borrowed reserves from $44 billion in early December to minus $8.8 billion at the end of January.

It isn't a mystery what happened. The Fed announced the creation of a Term Auction Facility on Dec. 12, enabling banks to borrow for 28 days versus a wide range of collateral. The minimum bid the Fed accepts is the expected funds rate one month out, which in the current environment means cheaper funding costs than the fed funds market.

So what would you do if you were a bank?

Lower Cost Loans made through the TAF are categorized as borrowed reserves. The Fed had $50 billion of loans in place at the end of January, which "caused the borrowed reserves figure to balloon and the non-borrowed figure to decline by a corresponding amount,'' said Lou Crandall, chief economist at Wrightson ICAP LLC in Jersey City, New Jersey, in a Feb. 6 commentary.

All of a sudden, people who never glanced at the Fed's H.3 statistical release are now experts on "Aggregate Reserves of Depository Institutions and the Monetary Base.'' Their e-mails have the same sense of foreboding as the missives put out by the Black Helicopter/Tin-Foil Hat crowd.

....

[The Tin-Foil Hat crowd] is overlooking the fact that the Fed is "a monopoly provider of reserves," said Jim Glassman, senior U.S. economist at JPMorgan Chase & Co.

"There is no such thing as a banking system short of reserves. The Fed has absolute control over the supply."

There may be times, such as late last year, when banks are reluctant to lend to one another for a period longer than overnight. "And any one bank can have a problem'' funding itself, Glassman said. But in a world where "the Fed can print money, there is no shortage," he said. "The banks get the reserves they want." ....

Glassman is flat out wrong.

There is indeed such a thing as a banking system being short of reserves. In addition, the Fed does not have absolute control over supply of reserves. Let's start with a discussion of how the TAF works and work our way to the correct conclusions.

Banks participating in the Term Auction Facility (TAF) have to put up collateral for the amounts they borrow.

Under the term auction facility (TAF), the Federal Reserve will auction term funds to depository institutions. All depository institutions that are eligible to borrow under the primary credit program will be eligible to participate in TAF auctions. All advances must be fully collateralized.

The Federal Reserve Banks accept a broad range of assets as discount window collateral. Discount window loans must be collateralized to the satisfaction of the local Reserve Bank. [Click here for more about Pledging Collateral.]

The Reserve Banks will consider accepting as discount window collateral any assets that meet regulatory standards for sound asset quality. A listing of the most commonly pledged asset types can be found by clicking on the Collateral Margins Table on this site. Depository institutions should direct questions regarding specific assets to local Reserve Bank staff.

Clearly, the Fed does not hand out reserves willy-nilly. It lends them, but only if banks have sufficient collateral. Furthermore lending is not "printing". Thus Glassman, the senior U.S. economist at JPMorgan Chase & Co. really needs an education here.

Still more education is required. The Fed does not have "control" over supply of reserves because it does not have control over assets held and loans made by member banks. If Glassman's thinking is representative of bank thinking in general, it's no wonder banks balance sheets are so $#@%'d up.

A shortage of reserves comes into play when banks no longer have sufficient collateral to exchange for temporary reserves. Banks that do not have sufficient collateral, do not get loans from the discount window or the TAF. Period. End of Story. The Fed does NOT simply "print money" and hand it out to capital impaired banks. Bankruptcies result.

Dozens of U.S. banks will fail in the next two years as losses from soured loans mount and regulators crack down on lenders that take too much risk, especially in real estate and construction, an analyst said.

The surge would follow a placid 3-1/2 year period in which just four banks collapsed, all in the last year, RBC Capital Markets analyst Gerard Cassidy said in a Friday interview.

Between 50 and 150 U.S. banks -- as many as one in 57 -- could fail by early 2010, mostly those with no more than a couple of billion dollars of assets, Cassidy said. That rate of failure would be the highest in at least 15 years, or since the winding down of the savings-and-loan debacle.

"The initial round of failures will come from smaller banks with limited access to capital and overexposure to commercial real estate," Cassidy said.

Analyst Tanya Azarchs expects the pain to spread to regional banks, and especially "some of the smaller players that have yet to feel the full extent" of the credit crunch.

Cassidy said: "The regulatory focus is now acutely on commercial real estate. The problems are centered around construction loans in residential housing. Home prices and sales are declining. This leaves builders unable to carry the debt they took on because they can't sell their homes."

A top U.S. bank regulator, Comptroller of the Currency John Dugan, said on Thursday that his office was prepared to intervene if banks with large real estate exposure maintained unreasonably low reserves for bad loans.

Over a third of the nation’s community banks have commercial real estate concentrations exceeding 300 percent of their capital, and almost 30 percent have construction and development loans exceeding 100 percent of capital. Here in Florida, as in other states where housing is so important to local economic growth, the concentration levels are more pronounced. Over 60 percent of Florida banks have CRE loans exceeding 300 percent of capital, and more than half have C&D loans exceeding 100 percent of capital.

We’re now entering a stage of the CRE credit cycle where problems have started to surface and losses have started to increase – which is the second inescapable fact I mentioned at the outset.

In terms of asset quality, our horizontal reviews have indeed confirmed a significant increase in the number of problem residential construction and development loans in community banks across the country.

Given these circumstances, what do we see as the consequences in the coming months? Not surprisingly, there will be more frequent interaction between supervisors and banks with concentrations in CRE loans that are declining in quality. There will be more criticized assets; increases to loan loss reserves; and more problem banks. And yes, there will be an increase in bank failures.

I want to emphasize today, as we see the clear signs of CRE credit quality declining, that we will expect banks with CRE concentrations to make realistic assessments of their portfolio based on current, changed market conditions. That may require you to obtain new appraisals. For those of you in stressed markets, it will almost certainly require you to downgrade more of your assets, increase loan loss provisions, and reassess the adequacy of bank capital.

I firmly believe that in this environment, increases in loan loss reserves for many banks are both warranted and prudent. I would be extremely surprised if your auditors disagreed with this position – but if they do with respect to a national bank, I urge you to contact your examiner-in-charge or Assistant Deputy Comptroller. If we have to intervene in this situation, we will not hesitate to do so.

Read this again and again until it sinks in:Over a third of the nation’s community banks have commercial real estate concentrations exceeding 300 percent of their capital, and almost 30 percent have construction and development loans exceeding 100 percent of capital.

There will be more criticized assets; increases to loan loss reserves; and more problem banks. And yes, there will be an increase in bank failures.

Why Will Banks Fail?

Banks will fail because they do not have sufficient reserves.

Banks cannot borrow those reserves because they do not have sufficient collateral.

The Fed's collateral requirements do not permit printing money and handing that money over to failing banks.

The Fed will not change those requirements and start printing money because of the "checkmate" scenario discussed below.

Does the Fed care about borrowed reserves?

Here's a statement that caught my eye from Baum's article made by one of my favorite economists, Paul Kasriel, chief economist at the Northern Trust Corp. in Chicago.

"There is no relationship between non-borrowed reserves and anything the Fed cares about, be it inflation, employment or real GDP."

On this point, I believe Kasriel is correct. However, the Fed has not been concerned about many things that history proves they should have been concerned about: housing, lending standards, derivatives, ARMs, and asset bubbles for starters.

Here's the deal. Bank reserves are net borrowed. This comes at a time when commercial real estate is about to plunge and bank balance sheets are loaded to the gills with them.

Finally, banks will not be going deeper to the "TAF well" as long as the rules state "All advances must be fully collateralized." Once collateral runs out, it's the end of the line.

If the Fed is not concerned about this situation, they soon will be.

Of course there are those who believe the Fed will break the rules and eliminate all collateral requirements. So far anyway, they have not done so. Let's assume however, when push comes to shove, the Fed acting under duress does just what Glassman says, and provides permanent capital for free.The Checkmate Scenario

Stop and think what massive printing would do to the US dollar and long term interest rates. It's called Checkmate. And that is why the Fed would not do what Glassman suggests, even if they could. The market won't allow it!

U.S. banks currently hold record amounts of mortgage-related assets on their books. If the housing market were to go into a deep recession resulting in massive mortgage defaults, the U.S. banking system could sustain huge losses similar to what the Japanese banks experienced in the 1990s. If this were to occur, the Fed could cut interest rates to zero but it would have little positive effect on economic activity or inflation.

Short of the Fed depositing newly-created money directly into private sector accounts, I suspect that a deflation would occur under these circumstances. Again, crippled banking systems tend to bring on deflations. And crippled banking systems seem to result from the bursting of asset bubbles because of the sharp decline in the value of the collateral backing bank loans.

Mish: So when does it all end?

Kasriel:

That is extremely difficult to project. If the current housing recession were to turn into a housing depression, leading to massive mortgage defaults, it could end. Alternatively, if there were a run on the dollar in the foreign exchange market, price inflation could spike up and the Fed would have no choice but to raise interest rates aggressively. Given the record leverage in the U.S. economy, the rise in interest rates would prompt large scale bankruptcies. These are the two "checkmate" scenarios that come to mind.

Who's Wearing The Tin-Foil Hats?

Few have been better at correctly calling out the Tin-Foil hats over the years as Caroline Baum. I am a Baum fan. I recommend her book "Just What I said". You can find it on my recommended reading list on the left. I did a review in Bookmobile: Master Traders & Just what I said.

In this case however, it is Jim Glassman, senior U.S. economist at JPMorgan (and anyone else who believes reserves will be printed into existence) who are wearing the Tin-Foil hats.

Things That "Can't" Happen will happen. And those with misguided faith in the Fed's ability and willingness to print reserves are in for a rude awakening.

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